It has been claimed that the accounting profession faces a serious litigation crisis, largely attributable to frivolous class‐action lawsuits that allege securities fraud. In response to recent calls for research on accounting litigation, this paper develops and analyses a game‐theoretic model of securities class‐action litigation and settlement under present institutional arrangements in the United States. Two research questions are examined. First, what factors explain the outcomes of securities lawsuits against independent auditors in the U.S.? Second, what (if any) strategies exist that accounting firms might employ to deter unwarranted securities litigation, coerced settlements, and other objectionable outcomes? Our results indicate that (1) settlements are the predominant outcome of the securities litigation game because both sides generally receive higher expected payoffs from settlements than from trials; (2) the prevalence of protracted pre‐trial litigation in securities lawsuits is primarily attributable to the method employed to compensate plaintiffs' attorneys; (3) the prevalence of settlement amounts that are generally a small proportion of claimed damages could result from strategic decisions by plaintiffs' attorneys, and hence does not necessarily indicate that securities lawsuits often have low merit as claimed by Arthur Andersen et al. (1992); and (4) effective strategies to deter securities litigation may be available to accounting firms, but effective implementation of these strategies may entail substantial short‐run costs.
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1 September 2002
